Opinion: Investors should be seen, not lost in the herd

By

JohnPrestbo

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April wasn’t the market’s cruelest month, but it nonetheless delivered an important lesson to those who haven’t grasped the concept of indexed investing.

The month started out on a slight upswing. But then shares of certain Internet darlings and biotech high-flyers started skidding. The broad market sagged, too. Investors of all stripes sat up and said the sky was falling.

Bull market will end when recession hits

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The current bull market will likely continue until the onset of the next recession, RBC strategist Jonathan Golub says. Photo: Getty Images.

Then came the guessing game. Was the economic recovery stumbling? Would international crises throw sand in the gears? Were the big gains of 2013 too much, too fast? Did you hear that China is slowing down more than anyone expected?

The correct answer was none of the above. It turned out that the declines were simply the result of hedge funds and other hot-money geniuses dumping those sectors at the same time. Which was nice symmetry since they had piled in together some months earlier. “Herd on the Street” is no myth.

Stocks spent the rest of the month trying to regain what they had lost. Some indexes have climbed back to levels they ended March with, and some have not. And therein lies the lesson about indexed investing.

The indexes and ETFs that were hurt the most in the April angst were those focused on sectors where the selling was concentrated. That makes sense, of course. But too many investors fail to appreciate that the diversification benefit promised by the baskets of stocks in ETFs is undercut if the stocks are just variations on a single theme.

So, for example, Facebook Inc.
FB, -1.26%
sank 9.5% in two days, but the concern that drop engendered spread to other Internet stocks and various segments of the technology industry. Ditto for the rippling effect on biotechnology of Gilead Sciences Inc.
GILD, -0.03%
, which plunged 11.5% in five days.

ETFs focused on those parts of the market fell sharply, too, because the concentrations of stocks in these segments amplified rather than muted the decline. Here are three examples of how much these ETFs declined (the nadirs being reached on April 11 or 14):

Indexed investing depends on diversification to deliver market-like returns and to minimize portfolio volatility. When investors use highly concentrated ETFs, even though they are based on indexes, they are exposed to the possibility of shocking results in both respects.

Of course, those who choose narrowly focused ETFs are aiming to beat the market rather than underperform. But intentions mean nothing in investing. Baseball great Babe Ruth excelled in both home runs and strikeouts.

Sectors aren’t the only way ETFs become concentrated and vulnerable. Some strategy-oriented ETFs share the same distinction. Momentum ETFs took it on the chin in April because many of their holdings were in biotech and the Internet. For example, PowerShares DWA Technology Momentum Portfolio
PTF, -0.34%
lost almost 8% in the first 11 days of the month.

The momentum strategy consists of focusing on stocks showing more relative strength than their peers. It is, to be frank, a strategy that calls out for active management because relative strength can accelerate or disappear quickly. Without constant vigilance, you could be missing out on better prospects as your holdings fade from glory.

But an index-based momentum ETF doesn’t allow you to pick and choose your components. They are, instead, part of the fund package, which reconstitutes the portfolio according to index rules — by the calendar, not the clock. The PowerShares ETF is reconfigured once a quarter, and turns over about 95% of its holdings annually.

Indexed investing doesn’t try to beat the market, but rather seeks to get the most out of what the market offers. As Vanguard Group founder John Bogle has put it innumerable times, classic index investing consists of (1) the broadest possible diversification, sustained over (2) the longest possible time horizon at (3) the lowest possible cost, thereby assuring (4) the highest possible share of investment returns.

The lesson of these past few weeks: Narrow, concentrated bets can turn against you due to factors beyond your control.

John Prestbo is retired as editor and executive director of Dow Jones Indexes, now part of S&P Dow Jones Indices, in which Dow Jones & Co., publisher of MarketWatch, holds a small interest. He also is an adviser to MarketGrader Capital, which scores stocks on the basis of fundamental factors and chooses components of the Barron’s 400 Index.

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